1. Derivatives and swaps on FX

2. Sections Futures Options Swaps

3. Futures contracts A futures contract is similar to a forward contract in that it specifies that a certain currency will be exchanged for another at a specified time in the future at prices specified today. A futures contract is different from a forward contract in that futures are standardized contracts trading on organized exchanges with daily marked- to-market resettlement through a clearinghouse. Settle price: a price representative of futures transaction price at the end of daily trading, which is determined by a settlement committee.

4. Futures contracts: Preliminaries Standardizing features: Contract size Delivery month Daily resettlement Initial performance bond (about 2 percent of contract value, cash or T-bills, held in a street name at your brokerage). Commission: buyers and sellers pay a single amount paid up front that covers the round-trip transactions of initiating and closing out the position. The commission can be as little as $15 per futures contract. Open interest: the total number of long or short contracts outstanding.

5. Currency futures markets The CME Group (formerly Chicago Mercantile Exchange) is by far the largest currency futures market. CME hours are 7:20 a.m. to 2:00 p.m. CST Monday-Friday. Extended-hours trading takes place Sunday through Thursday (local) on GLOBEX i.e. from 5:00 p.m. to 4:00 p.m. CST the next day. Expiration cycle: March, June, September, December. The delivery date is the third Wednesday of delivery month. The last trading day is the second business day preceding the delivery day.

6. Reading currency futures quotes In general, open interest typically decreases with term to maturity of most futures contracts. At the June settlement price of 1.3087, the holder of a long position in one futures contract is committing himself/herself to paying $163,588 (1.3087 × 125000) for €125,000 on the delivery day. Futures can be use to hedge: you know for sure (risk reduction) about the price today, say 1.3087, for delivery in the future. OPENHIGHLOWSETTLECHG OPEN INTEREST Euro/US Dollar (CME)—€125,000; $ per € 1.30841.31181.30541.3087.0005June233,380 1.30891.31261.30621.3094.0006Sept6,814

7. Example Consider a long position in the CME €/$ contract. It is written on €125,000 and quoted in $ per €. The purchase price is $1.30 per €. The maturity is 3 months. At initiation of the contract, the long posts an initial performance bond of $6,500. The maintenance performance bond is $4,000. You get a margin call when your (equity) position erodes by $2,500. If you fail to do so, the position will be closed out with an offsetting short position.

8. Daily resettlement With futures contracts, we have daily resettlement of gains and losses rather than one big settlement at maturity. Futures payoffs are a zero-sum game. Every trading day: If the price goes down, the long pays the short. If the price goes up, the short pays the long.

9. Example - continued Over the first 3 days, the euro strengthens then depreciates in dollar terms: $1,250 –$1,250 $1.31 $1.30 $1.27 –$3,750 Gain/LossSettle $7,750 $6,500 $2,750 Account Balance = $6,500 + $1,250 On day three suppose our investor keeps his long position open by posting an additional $3,750. + $3,750 = $6,500

10. Futures pricing The pricing of futures contracts is similar to that of forward contracts. Thus, we can use the interest rate parity (IRP) to price futures: In American terms, (F – S) / S = (i D – i F ) / (1 + i D ) ≈ i D – i F

11. Speculating with futures Suppose that you took a long position today in one December € futures at $1.3094/€. You hold it until it expires on the third Wednesday of December. The spot rate that day is $1.2939/€. The standard contract size is €125,000. Your speculative loss is (1.2939-1.3094) × 125,000 = -$1,937.50. In contrast, if you had taken a short position, your speculative gain is $1,937.50.

12. Options contracts An option gives the holder the right, but not the obligation, to buy or sell a given quantity of an asset in the future at prices agreed upon today (i.e., exercise price). Calls vs. Puts: Call options give the holder the right, but not the obligation, to buy a given quantity of some asset at some time in the future at prices agreed upon today. Put options give the holder the right, but not the obligation, to sell a given quantity of some asset at some time in the future at prices agreed upon today.

13. Options European versus American options: European options can only be exercised on the expiration date while American options can be exercised at any time up to and including the expiration date. American options are usually worth more than European options, other things equal. Premium: option price; the cost of acquiring an option.

14. Options market The over-the-counter market written by international banks, investment banks, and brokerage houses is very active. Generally, these contracts are tailor-made and are written for large amounts, at least worth of $1 million of the currency serving as the underlying asset. These contracts are often European style. Philadelphia Stock Exchange (PHLX), part of the NASDAQ QMX Group, have currency options as well. But the trading volume is much smaller than that in the OTC market.

15. PHLX currency option specifications CurrencyContract Size Australian dollarAUD 10,000 British poundGBP 10,000 Canadian dollarCAD 10,000 EuroEUR 10,000 Japanese yenJPY 1,000,000 New Zealand dollarNZD 10,000 Swiss francCHF 10,000

16. Option payoffs at expiration At expiry (T), an American option (a) is worth the same as a European option (e) with the same characteristics. If the call is in-the-money, it is worth S T – E., where S T is the spot rate at expiration, and E is the exercise price. If the call is out-of-the-money, it is worthless and its payoff, C, is: C aT = C eT = Max[S T – E, 0] If the put is in-the-money, it is worth E – S T. If the put is out-of-the-money, it is worthless and its payoff, P, is: P aT = P eT = Max[E – S T, 0]

17. Example Consider a PHLX € European call option. The standard contract size is €10,000. The premium paid was $0.0252 per €. The exercise price is $1.30 per €. Suppose the spot rate at expiration is $1.3425/€. The call has an exercise payoff of 10000 × 0.0425 (=1.3425 – 1.30) = $425. The call cost the investor 10000 × 0.0252 = $252. Thus, the profit for this trade is: 425 – 252 = $173. Now suppose that the spot rate at expiration is below $1.30/€. The investor will simply throw away this option and incur a loss for this trade in the amount of $252.

18. Call option profit profiles E STST Profit Loss –c 0 E + c 0 Long call If the call is in- the-money, it is worth S T – E. If the call is out- of-the-money, it is worthless, and the buyer of the call loses his entire investment of premium c 0. In-the-money Out-of-the-money Short call

19. Put option profit profiles E STST Profit Loss – p 0 E – p 0 Long put E – p 0 If the put is in- the-money, it is worth E – S T. The maximum gain is E – p 0 (p 0 being premium). If the put is out- of-the-money, it is worthless, and the buyer of the put loses his entire investment of p 0. Out-of-the-moneyIn-the-money Short put

20. American call prior to expiration E STST Payoff Long call The red line shows the intrinsic value; i.e., the payoff of immediate exercise. Note that even an out-of-the-money option has value because of time value. Intrinsic value Time value Market Value In-the-money Out-of-the-money

21. Currency futures options Currency futures options are options on a currency futures contract. Exercise of a currency futures option results in a long futures position for the holder of a call or the writer of a put. Exercise of a currency futures option results in a short futures position for the seller of a call or the buyer of a put. If the futures position is not offset prior to its expiration, foreign currency will change hands.

22. Hedging with currency option Adamant Inc. of Vermont imports Italian wine. On November 1 st it bids €62,500 for a batch of rare wine, but it will not know until December 15 th whether the bid is accepted. To protect against a possible appreciation of €, it purchases a €62,500 call option. The strike price is 1.2750 $/€ and the option premium is 0.5 cent per euro. Thus the option costs $312.5 (= 62500 × 0.005).

23. Hedging outcomes If the euro appreciates to 1.3000 $/€, the payment without the option would be $81,250 (=62500 × 1.3). Adamant Inc. will surely exercise the option and purchase the euro for 1.2750, which is a payment of $79,687.5 (= 62500 × 1.275)+ premium of $312.5. If the euro depreciates to 1.2000 $/€, the firm will be better of buying euro on the spot market, so it let the option expire unused. The payment is then $75,000 + premium of $312.5

24. Swaps Forwards, futures, and options have maturities no longer than 1 year. Swaps are often multiple years. In a swap, two counterparties agree to a contractual arrangement wherein they will exchange cash flows at periodic intervals. There are two types of interest rate swaps. Single currency interest rate swap “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps. Cross-currency interest rate swap This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

25. Swap market The notational principal of: Interest rate swaps is about $400 trillion USD. Currency swaps is about $30 trillion USD. The most popular denominating currencies for swaps are: U.S. dollar Japanese yen Euro Swiss franc British pound sterling

26. Swap bank Swap bank is a generic term to describe a financial institution (international commercial bank, investment bank, or independent operator) that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer (most likely a dealer nowadays). As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer (market maker), the swap bank stands ready to accept either side of a currency swap and then later lay off the risk, or match it with a counterparty.

27. Swap products Swap banks can tailor the terms of interest rate and currency swaps to customers’ needs. They also make a market in “plain vanilla” (i.e., rather generic, standardized) swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

28. Generic swap quotations Euro-€£ SterlingSwiss francU.S. $ BidAskBidAskBidAskBidAsk 1 year0.320.360.510.540.060.120.320.35 2 year0.440.480.680.720.110.190.420.46 3 year0.590.630.810.850.200.280.630.66 4 year0.770.810.971.020.340.420.890.92 5 year0.950.991.151.200.490.571.171.20 6 year1.141.181.351.400.660.741.451.48 7 year1.301.341.551.600.830.911.691.72 8 year1.461.501.741.790.981.061.911.94 9 year1.601.641.921.971.111.192.092.12 10 year1.741.782.082.131.211.292.252.28 1.74–1.78 means the swap bank will pay fixed-rate euro payments at 1.74% against receiving USD LIBOR or it will receive fixed-rate euro payments at 1.78% against receiving USD LIBOR.

29. Generic fixed-for-floating swap Consider a 5-year swap with semiannual payment 8.50- 8.60 % against 6-month dollar LIBOR flat (flat means no credit premium; i.e., the best rates for counterparty with the highest credit rating). The swap bank will pay semiannual fixed-rate dollar payments of APR 8.5% against receiving 6-month dollar LIBOR (of course, LIBOR is floating). The swap bank will receive semiannual fixed-rate dollar payments of APR 8.6% against paying 6-month dollar LIBOR. The spread of 0.1% is the revenue for the swap bank.

30. A case for interest rate swap, I Consider a AAA-rated regional bank A that needs $10 million to finance a floating-rate loan to its client. Interest rate risk management: for this financing, it is ideal for bank A to issue 5-year floating-rate notes indexed to LIBOR (floating-rate assets matched with floating-rate liability). Alternatively (presumably less ideal without a swap), Bank A can issue 5-year fixed-rate bonds at 10%. The swap bank instructs bank A to do the alternative financing: issue fixed-rate bonds at 10%.

31. A case, II Company B is a BBB-rated manufacturing firm that needs $10 million to finance a new investment project with a life of 5 years. Maturity matching: ideally, company B prefers the issuance of 5-year fixed-rate bonds at 11.25%. Alternatively, company B can issue 5-year floating-rate notes at LIBOR + 0.5% (credit premium because of BBB). The swap bank instructs company B to do the alternative financing: issue floating-rate notes at LIBOR + 0.5%.

32. A case, III Firm B Bank A 10.50%10.375% Swap Bank LIBOR  The swap bank performs a swap with bank A and company B being counterparties, set the prices at 10.375%-10.50%, and makes 0.125% on the deal.  Note that the spread, 10.375% and 10.50%, are sandwiched by the fixed rates, 10.00% and 11.25%, bank A and company are able to achieve.

33. A case, IV All-in cost (net cash outflows) for bank A: LIBOR – 10.375% + 10% (the alternative fixed-rate bond APR) = LIBOR – 0.375%. This is cheaper (by 0.375%) than the ideal LIBOR financing. All-in cost for company B: 10.50% - LIBOR + [LIBOR + 0.5% ] = 11%, where {LIBOR + 0.5%] is the alternative financing cost. 11% is cheaper (by 0.25%) than the ideal fixed-rate bond APR of 11.25%.

34. In short It is a win-win-win situation. Swap bank creates business. Bank A got its LIBOR cash flows with a saving of 0.375%. Company B got its fixed-rate cash flows with a saving of 0.25%. But how does this happen?

35. Quality spread differential In this case, quality spread differential exists. That is, the default-risk premium differential on the fixed-rate debt, 1.25% (= 11.25% - 10.00%), is larger than the default-risk premium differential, 0.5% (= [LIBOR + 0.5%] - LIBOR). This creates a possible total saving of 0.75% ( = 1.25% - 0.5%). This 0.75% saving/efficiency is shared by the swap bank (0.125%), bank A (0.375%), and company B (0.25%). Bank A prefers floating-rate notes, but it has competitive advantage in issuing fixed-rate bonds.

36. A case for currency swap, I Consider a U.S. MNC desires to finance a new investment project in the amount of €40 million in Germany. This German operation has a life of 5 years. The current spot rate $/€ = 1.30. FX risk management: ideally, the firm would prefer to issue €- denominated 5-year fixed-rate bonds at 7%. Note that 7% is fairly high by the Eurozone’s standard because the U.S. firm is less known in the Eurozone. Alternatively (presumably less ideal without a swap), the firm can raise $52 million (= 40 × 1.3) by issuing 5-year fixed-rate dollar bonds at 8%, then convert $52 million into €40 million. The swap bank instructs the U.S. firm to do the alternative financing: issue fixed-rate $-denominated bonds at 8% in the U.S.

37. A case, II A German MNC has a mirror-image financing need. It desires to finance a new investment project in the amount of $52 million in the U.S. This U.S. operation has a life of 5 years. FX risk management: ideally, the firm would prefer to issue $- denominated 5-year fixed-rate bonds at 9%. Note that 9% is fairly high by the American’s standard because the German firm is less known in the U.S. Alternatively, the firm can raise €40 million by issuing 5-year fixed-rate €-denominated bonds at 6%, then convert €40 million into $52 million (= 40 × 1.3). The swap bank instructs the firm to do the alternative financing: issue fixed-rate €-denominated bonds in the Eurozone at 6%.

38. A case, III German MNC U.S. MNC $ @ 8.1%$ @ 8% Swap Bank € @ 6.1%€ @6%  The swap bank performs a swap with bank A and company B being counterparties, and makes 0.2% on the deal.

39. A case, IV All-in cost (net cash outflows) for the U.S. MNC’s € borrowing via swap: 6.1%. This is cheaper (by 0.9%) than the ideal 7% € borrowing. All-in cost for the German MNC: 8.1%. This is cheaper (by 0.9%) than the ideal 9% $ borrowing. The efficiency arises because the U.S. MNC has comparative advantage issuing debt in the U.S., and the German MNC has comparative advantage issuing debt in the Eurozone.

40. End-of-chapter Chapter 7: Questions 1, 2, 5, 6; Problems 1, 2, 4-8. Chapter 14: Questions 1-5, 9; Problems 1-3.